ETF Defenses For The Fiscal Cliff And Beyond

Adam Patti is the Chief Executive Officer and Founder of IndexIQ, a New York-based ETF issuer behind several of the most innovative ETF products to hit the market in recent years. He recently took time out of his busy schedule to discuss IndexIQ’s various products as well as how investors might be able use his firm’s ETFs to protect themselves from the looming fiscal cliff and inflation [see Free Report: How To Pick The Right ETF Every Time].

ETF Database (ETFdb): In your opinion, what aspect of the “fiscal cliff” is most concerning to individual investors?

Adam Patti (AP): From a high level, I believe the most concerning issue is the general economic uncertainty which has translated to increased volatility. A failure to avert the “fiscal cliff” will likely manifest itself in many ways. The most immediate issue will be the increase in marginal tax rates which, in the near-term, may affect the level of consumer spending this holiday season. Any decrease in consumer spending is particularly concerning this time of year since holiday spending typically makes up around 20% of total retail sales annually.

Longer-term, the real consequences are quite a bit more dire. First, the economic drag of higher taxes, with the related decrease in consumer spending, combined with the stipulated spending cuts will likely depress already anemic GDP growth, throwing our country back into recession. This, in turn, may lead to a drastic increase in layoffs, a pullback in stock market valuations and an overall reduction in consumer and investor confidence, among other things [Download 101 ETF Lessons Every Financial Advisor Should Learn].

The nightmare scenario one step beyond this is of course that the politicians fail to reduce our spending trajectory, driving increasingly unsustainable debt levels. This will result in additional credit rating downgrades, higher interest rates and the possibility of high inflation.

ETFdb: Do you think there is a “worst case scenario” that investors can actively protect themselves against?

AP: There are a variety of scenarios which don’t bode well for investors. However there is always the possibility for a positive resolution. History shows that investors are typically poor market timers, thus going to cash is not an effective long-term strategy. Typically investors who do such a thing will miss the upside in the market, much of which occurs in the early stages of an upward market cycle. If you miss the early upswing it is very difficult to produce acceptable investment returns over time.

The solution to this is to put together an asset allocation plan and stick to it. In volatile markets like today, perhaps that plan tactically shifts to a more defensive posture with greater cash balances and use of more conservative asset classes. However the key in any market environment is to be hedged. Institutional investors have long used hedged investment strategies to both protect against the downside in tough markets, and to retain their upside potential in case the market improves.

It is only recently that non-institutional investors have had access to high-quality alternative investment strategies with multi-year track records.

ETFdb: What strategies do you view as potentially effective for investors looking to scale back risk ahead of the new year without necessarily going all to cash?

AP: Alternative investments should be used as part of an investor’s portfolio. The precise amount depends upon both an investor’s objectives and which asset classes one considers to be “alternative.” Taking liquid hedge fund exposure as an example, my experience is that the average investor typically should allocate approximately 20% of their portfolio to such vehicles. This would significantly reduce overall portfolio volatility, provide downside protection, and allow investors to retain upside potential for any rebound.

For example, our flagship ETF, IQ Hedge Multi-Strategy ETF (QAI) has experienced approximately 5-7% volatility with a 1.5-2% dividend yield through its 3½ years of live history. QAI is often used as a core portfolio holding in the 10% range. Another example would be the IQ Hedge Market Neutral ETF (QMN), which has a volatility profile of approximately 3-5% and is designed to provide positive returns across market conditions [see also Inside The A+ Hedge Fund ETF].

Cash is a tricky thing. As we know, cash isn’t providing much yield, so it could be dangerous to keep too much on hand, unless an investor has specific spending needs to account for or is planning to try to time the market and enter at a low point. The latter of which is not something I would recommend.

To alleviate the significant drag on portfolio returns that holding actual cash provides, I would point to the IQ Real Return ETF (CPI). CPI is designed to deliver a 2-3% real return above short-term Treasuries with volatility of around 2% and has achieved exactly this over its 3-year live history. CPI has also proven itself to be superior to TIPS bond funds as a vehicle for insulating investor portfolios against inflation.

AP: We found that investors who are fearful of inflation have historically piled into TIPS funds and gold due to the belief that these would protect them against the ravages of inflation. We believed that this was a flawed strategy and that we could offer a more compelling option. Our research team, including our academic board, conducted in-depth research on this topic and found two things:

Gold is not necessarily a great inflation hedge as a standalone strategy. We found that the price of gold is heavily influenced by market sentiment and related investment flows.

TIPS bond portfolios make for very poor inflation hedge strategies as well. There are many reasons for this, but the main ones are that TIPS portfolios are, by definition, laddered portfolios (as they include bonds of various durations), so they are embedded with significant duration risk. We also found that TIPS portfolios are quite volatile, don’t correlate to inflation very well, and in fact experience price movement based more on investor inflows then actual inflation. The duration risk alone puts investors at great risk if interest rates rise, particularly given the over-valued nature of these portfolios in part due to the market impact of billions of inflows. If you were to buy a single TIPS bond when issued and hold it to maturity you would likely achieve your objective, but most investors opt to buy packaged products like TIPS ETFs and Mutual Funds which exhibit the characteristics summarized above.

We then drafted a white paper which can be found on our website (www.indexiq.com) analyzing inflation drivers going back 100 years. What we found is that the most effective way to hedge inflation risk is through a multi-asset class approach. The reason for this is that there are many asset classes that have sensitivities to inflation. These sensitivities change based on what type of inflation we are experiencing. We also found that while short-term Treasury securities are an excellent proxy for the inflation rate itself, in order to get a real-return above that inflation rate, a multi-asset class portfolio is superior to options such as gold and TIPS bond funds.

Based on this research, we developed CPI, which is the first such ETF on the market and now has over 3-years of track record, with live index history that goes back even further, to December 2008. The product is 100% rules based and very simple in that it has a consistent core holding of short-term Treasuries and then has access to 11 other asset classes which rotate in and out of the portfolio monthly based on what we see impacting the Consumer Price Index. When inflation is low like it has been over the past few years, short-term Treasuries will make up a larger portion of the portfolio then when inflation rates spike higher [see also 25 ETF Ideas To Fight Rising Prices].

ETFdb: How big of a threat is inflation over the next year or so considering that spending cuts, tax hikes, or more borrowing are all likely to drag on economic growth?

AP: Exactly how much of a threat inflation poses is unclear, however, most economists agree that while the Consumer Price Index has not shown much reason for concern, other areas of the economy tell a vastly different story. One need only look at commodity and food prices, or healthcare and education costs to see inflation in action. The question then becomes whether a possible economic slowdown will counteract the impact of all the fiscal stimulus we’ve seen in recent years.

On the flip side, the impact of a strengthening economy, combined with exceedingly low interest rates, provides a different set of issues related to inflationary pressures. Given this uncertainty, a wise investor will be prepared for either scenario.

ETFdb: What advantages does your CPI ETF offer over other inflation-fighting securities?

AP: CPI is superior to other “inflation-fighting” options because it is a complete core solution designed to hedge inflation in all inflationary environments, while at the same time offering low volatility. If you look at the volatility of some of the TIPS bond ETFs, you will see 8-9% volatility and a price profile well above historical norms, factors which will become very dangerous in a rising rate environment.

Investors are using CPI to equitize their strategic cash balances, as a replacement to short-term bond allocations, or complement to TIPS and gold allocations. Some investors are also using CPI as a tool to barbell their inflation protection allocation, using CPI on the short duration side and traditional TIPs bond ETFs on the long end. However, they’re using it, what they’re finding is a product that is performing as designed, while providing a liquid, low-cost, fully transparent means of protecting against inflation in what remains a very volatile and unsettled time in the markets.

Bottom Line: The looming fiscal cliff and global economic uncertainties have certainly proved to be challenging for investors and issuers alike. Innovating issuers, such as IndexIQ, have responded to investor’s needs by providing them with cost-efficient and effective tools to protect their portfolios against market volatility, inflation, and other disruptions.

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